How Government Tax Debt Forgiveness Programs Generate Massive Tax Debt

People who are exhaling a sigh of relief because their student loan debt is now in line with their income may want to reconsider the rules that originally established the income-based payment. A tax time bomb might be lurking and silently ticking away. Defusing it isn’t a major topic of the current policy debate in Washington due to America’s focus on student loan debt and job security… but we have been keeping a watchful eye and our projections might shock you…

Does Forgiven Student Loan Debt Subject You to Taxes?

Should you be required to pay income taxes on the loan balance that the government cancels if you’re enrolled in the income-based repayment plan?

This conceivable tax bill is a result of federal efforts, such as the recently expanded income-based repayment program, which let you only make the minimum payments on the majority of federal loans that you can afford to make each month. Your payment is determined by a formula that considers your income. The federal government then cancels any outstanding debt, typically after 10 to 25 years.

The catch is in the forgiveness because, in general, you have to pay income taxes on any forgiven debt (unless you were in a program for teachers or worked in public service, in which case the taxes are waived). The tax bill could be well into the five figures for many people, especially those who graduated from graduate or professional school with debts of six figures. And when it does, you are required to make a full payment right away.

It’s a difficult task that few experts have attempted: estimating how many people will be in this situation and how large the tax bill might be.

Starting with the repayment programs themselves will help organize everything. In the 1990s, some people opted to receive income-based payments. The Obama administration changed the income-based program, which was introduced more recently, to make it more generous by shortening the repayment periods and changing the formula used to calculate the monthly bill.

According to data from the Education Department as of October 31, about two million people had requested income-based repayment. According to the program’s guidelines, about 1.3 million people had low enough income and high enough debt payments under standard repayment plans to be eligible for reduced payments. There were still 440,000 pending applications.

The popular federal Stafford student loans were obtained by more than 10 million people during the 2011–12 academic year, according to the College Board’s Trends in Student Aid report. In a report earlier this month, Cooper Howes, an analyst at Barclays, estimated that more than half of all borrowers would be qualified for payment reductions due to their incomes.

You should visit the Project on Student Debt’s ibrinfo.org website if you or your children are borrowers and are unfamiliar with the income-based repayment program. It is the most straightforward resource available on this difficult subject. The website of the Education Department and the income-based repayment calculator of the New America Foundation are both worthwhile visits. These and other relevant information sources are all linked throughout the Web version of this column.

Finding the extent of the impending tax problem becomes increasingly difficult pretty quickly. Not all eligible students will sign up for income-based repayment because some will not be informed of it, will disregard it when they are, will believe they cannot qualify or will be told (incorrectly) that they cannot, or will fear there is a catch. It is extremely difficult to predict how many of those who sign up will eventually have some debt forgiven a few decades from now.

However, Jason Delisle, director of the federal education budget project at the New America Foundation, who has written extensively about the income-linked repayment programs, mentions an Office of Management and Budget initiative that made an attempt at it. The O.M.B. predicted that 400,000 borrowers between 2012 and 2021, with an average loan balance of about $39,500 at the outset, would each eventually receive loan forgiveness of about $41,000. You did read that correctly. Even though it was forgiven many years later, the amount will be greater than the initial balance.

Depending on your tax bracket, the federal tax obligation at $41,000 of loan forgiveness could easily be over $10,000. Depending on where you live, state income taxes may also be an issue.

However, the sums could be much higher. Following a divorce, Stephanie Day completed her bachelor’s degree in her 40s with the goal of going into social work. When the recession was at its worst and she was unable to find employment, she went back to school to earn a master’s in psychology to strengthen her resume.

Even then, she found it difficult to find employment close to her home in Seattle, so she moved to a town on the border of New Mexico and Texas in search of a position there. She returned to Seattle after a home invasion and a miserable year of being away from her kids, paying just $30 per month toward her roughly $80,000 in debt under the income-based repayment plan.

Given that her unpaid balance keeps increasing as a result of the low payments, Ms. Day has done the math and anticipates a situation in which the government will forgive more than $100,000 of her debt. Despite her disappointment that so few people were aware of the impending tax bill, she said she was not particularly opposed to paying it. “I believe it to be completely fair,” she said. “I guess you could say I’m traditional.”

I do want to point out that if you need the income-based repayment plan, you shouldn’t let concerns about a tax bill in the future keep you from applying. Any participant in the plan, regardless of how the numbers shake out, needs to give serious consideration to setting aside money for their eventual tax bill.

Even if the bill is very high, there are severe consequences for not paying it right away. Sadly, if you are in financial difficulty (for example, your expenses exceed your income), the Internal Revenue Service has programs available to help you pay off tax debts. Additionally, if you are insolvent (which most people are), you might be able to deduct a sizable portion of the forgiven debt from your taxes. Another justification for why speaking with a tax professional from Advocate Tax Solutions is crucial to avoiding a sizable future tax burden! For a free and private tax consultation, contact us at 888-737-0200, toll-free.